Islamic Finance: Sharia screening works to protect investors

In this last article of a series on Islamic funds, we will examine how effective the Sharia screening process is in safeguarding investors' interests.

As explained earlier, the following are the essential screening parameters that make a company eligible for entry into an Islamic index and from there to an Islamic fund:

a) The company's activities should not include liquor, pork, hotel, casino, gambling, cinema, music, interest-bearing financial institutions, conventional insurance companies, etc.

b) The total interest-bearing debt of the company at any point in time should remain below one-third of its average market capitalisation during the last 12 months.

c) The sum of a company's cash and interest-bearing securities must not be greater than 33 per cent of its trailing 12-month average market capitalisation.

d) Its aggregate of account receivables should remain below 45 per cent of the total assets.

The manufacturers of tobacco and weapons/ammunition, although not clearly forbidden for investment under Sharia, are also excluded from the index under advice from scholars due to the known harmful affects of these industries on a society.

The index managers strictly monitor the measures approved by the panels of reputable Sharia scholars on an ongoing basis. A company is removed from the index if it fails to meet any of the above litmus tests. The integrity of an Islamic index is regarded by the frequency of periodic reviews conducted by its Sharia board.

Have the said screening parameters ever proved effective to the benefit of the investors?

Yes, it is a matter of surprise but Islamic investors breathed a sigh of relief in the middle of last year upon knowing that their fund managers had liquidated WorldCom shares (the giant U.S. telecom company with a valuation tag of about $200 billion) as early as by the third quarter of 2001.

The decision to remove WorldCom was taken simply because its debt ratio had far exceeded the said Sharia barrier.

Fund managers around the world follow Islamic indices and when the company was removed from renowned Islamic indices, they were forced to sell off WorldCom shares at a decent $14 per share compared to naught upon the company's collapse.

There are numerous other glaring examples, the major ones being Enron and Tyco where Islamic fund managers had come out unscathed, well ahead of the collapse of these conglomerates like a house of cards.

There is no magic power behind these safe passages. It is simply strict adherence of the Sharia parameters set by the scholars with great care.

The above significant developments, taking place one after the other, provided much-needed support to the very concept of Islamic indices and funds.

Investors around the globe took notice of the aforementioned prudent measures adopted by the managers of the Islamic indices and now keep regular vigil as to the equities being added or removed from them.

It may sound bizarre but the multinational public joint stock companies around the world with activities within the ambit of Islamic ideology are getting increasingly wary of the above screening parameters, especially their debt levels. As such, the sudden recognition of the genius of Islamic indices and fund managers has started to work as quasi-regulatory.

The Islamic funds mart considered a rarity until the late 1990s is now buzzing with activity. Many prime banks with established brand names and large networks are already playing or seeking to play some role in launching or getting associated with an Islamic fund.

These banks find the idea attractive for their risk-shy clients who would not normally look at a high-risk conventional fund.

Furthermore, the massive Muslim population in the world makes the statistical work easy for these banks, as there is great scope for growth of Islamic funds within the Islamic world itself, especially the financially rich Gulf countries.

The current need is that Islamic banks should endeavour to introduce Islamic financial products, especially funds, into the Islamic countries as well as the West and the other non-Muslim countries by tying up the arrangements with their counterparts.

The writer is Head of Risk Management at Dubai Islamic Bank.